Thoughts from the Frontline

This week we look at index funds, and specifically at problems that certain types of capitalization weighted index funds have. It is intuitively obvious that capitalization-weighted indexes have a larger proportion of their assets in the larger stocks. (Capitalization-weighted means that larger stocks are given more "weight" or proportion of the index or fund.) But is this what a rational investor should actually want? I think the information we look at today will surprise many. On my way in to Las Vegas last Wednesday, I read a very interesting op-ed piece by Professor Jeremy Siegel of Wharton Business School. Basically, he says that "Fundamentally weighted indexes are the next wave of investing." On May 13 of 2005, I highlighted new research by good friend Rob Arnott, where he laid out the intellectual and practical arguments for a new type of fundamentally weighted index. By that, I mean that he says stock indexes and the funds associated with them should be based upon the underltying fundamentals of the companies and not just the size of the company. At that time I said his work would be the basis for a revolution in investing and would become hugely successful. The last year has proven me right. And now, these ideas are becoming mainstream enough to make the Wall Street Journal .

Is the Fed right to be worried about inflation, or is that so last quarter? What do musty old academic papers suggest about Fed policy? And can we translate that into something that gives us a clue as to why markets around the world are in seeming lockstep on their way to the exits? (Quick, guess which market has done the best in the last month. No peeking!) Whatever happened to the diversification of our portfolios? This week we look at a wide range of topics trying to get some insights into where the markets are headed this summer. First, let's look at the world equity markets. I had my new assistant, Micah Davis, do a search for how the world equity markets have done this year from their recent peaks. All in all, we looked at 64 markets. I assumed we would have at least a few up markets. There always seems to be some market somewhere that can buck a downtrend. Interestingly, all 64 markets are off their recent highs. Two-thirds of world markets are down 10% or more, with Middle Eastern markets in free fall for the past few months. Indeed, they seem to have been a warning sign of trouble, as they have led the way down.

The Fed tells us that whether or not they continue to hike short-term rates is now dependent upon the data. Since that has always been the case (I mean, has there ever been a time when they ignored the data?), what they are really saying is "We are not really sure what we are going to do at the next meeting, so we will look at the recent data and make up our minds at that point." I actually find that rather hopeful. In the past, it has been typical for the Fed to just keep raising rates until the economy is on the way to or already in a recession or a serious slowdown. Since the economy has been doing just fine of late and, as we will discuss later, inflation is running high enough to make a Fed governor uncomfortable, then past performance would indicate that they would continue on their rate-hiking mission. It takes 12-18 months for interest rate hikes to actually have an effect on the economy. Thus, there is a considerable amount of lag time between Federal Reserve interest rate actions and the results being seen in the economy. So, not only will the Fed be looking at current data, which reflects actions taken over a year ago, but they will be analyzing forward-looking projections as well.

Can you have too much of a good thing? And specifically, can targeting low inflation and stable prices create problems that are even larger than the ones a stable price policy is trying to avoid? Today we look at a very interesting set of ideas proposed by one William R. White of the Monetary and Economic Department of the Bank of International Settlements (BIS). The BIS can be understood to be a kind of a central banker's central bank. So when they talk about appropriate central bank policy, those of us much lower on the food chain should pay attention. Let's look at one paragraph in particular, which I am sure will show up in bearish commentary all over the world: "Should any or all of these series revert to their historical means, the sustainability of future global growth would also be open to question, perhaps leading to a deflationary rather than an inflationary outturn. To combine the two possibilities, the worst case scenario would be inflationary pressures, leading to a sharp tightening of policy, which in turn could precipitate a process of mean reversion in a number of markets simultaneously."

This week I am in La Jolla for my annual Strategic Investment Conference. It is packed, and of course I am quite busy, so not much time to write my regular e-letter. But a few weeks ago, Rich Smith from The Motley Fool did a fairly wide-ranging interview with me that just came out this week, and I thought he did an excellent job in putting together a coherent piece from what was a long conversation covering a lot of topics. So, let's see what Rich found interesting in my musings. By Rich Smith Do you have a net worth of $1 million? Own a hedge fund? If the answer to one of those questions is "yes," then chances are that you know John Mauldin -- president of Millennium Wave Advisors, author of the weekly e-letter "Thoughts from the Frontline," and perhaps the leading proponent of the theory that America is in the midst of what he calls a secular bear market. When you need a big-picture view of what's going on in the economy, John Mauldin is the guy to ask. Fool contributor Rich Smith did just that.

This week we look at the links between the US trade deficit, the low savings rate in the US, home prices, and interest rates, all in an effort to answer the question: "Do trade deficits matter?" I think I will offer a few practical, if simple, insights to the matter. At the end of last year, I did a series of e-letters on the debate over dinner in London between Bill Bonner and Charles and Louis-Vincent Gave. Both had just published a book. Bill's book, Empire of Debt (which is still doing well) states that the US trade deficit, coupled with massive government and consumer debt, is going to drive the dollar to its knees and end up with the US in a soft depression. You can chalk it safely in the doom and gloom column.

Is the market overvalued? Fairly valued? Or are there really rocket boosters underneath the trading floors? We will look at the data, some historical charts which I think you will find very interesting, and some of the recent economic numbers which are important, all in an attempt to answer these questions. This week's letter was prompted by a very fair question from a reader. I got in late Tuesday night to Orlando where I would speak to the Investment Management Consultant's Association the next morning. I went to the bar to get a glass of wine and see if I could meet anyone from the conference and get a feel for what was happening. Coincidentally, I immediately met two readers who were attending the conference, and we struck up a conversation. One had been reading me for quite awhile and has read my books. It did not take long before he asked, "Do I still believe we are in a secular bear market? And if the market makes new highs, what will happen to my belief in that premise?" As if to underscore that thought, today the Dow closed at 11,577, a six-year high. Various small-cap markets are at actual all-time highs.

Be careful what you wish for. You just might get it. This week we look at a more transparent Fed, Japanese monetary policy, the powerhouse rise of gold, and a rather important op-ed piece in the Wall Street Journal , with a theme of seeing how they all impact the dollar. There is more than a little intrigue in the markets, and we try and make sense of it. We are going to quote a number of friends who each give us a piece of the puzzle, and see what it all means. But I'll give you a preview: it means more volatility and a weaker dollar. But first, let's have some fun. The following is a link to a very funny satirical music video by the students at the Columbia Business School (first sent to me by Gary North among a host of friends). This takes a little set-up to understand some of the inside jokes. It is set to the tune of the old Police hit, "Every Breath You Take." It makes fun of the fact that the Dean of the Business School, Glenn Hubbard, former chairman of the Council of Economic Advisers to the President, wanted to be Fed chairman. CBS refers to Columbia Business School and not the TV network. Major kudos to the kids who did this! And for those of you who aren't familiar with Hubbard's face (after all, he is an economist), the student who "plays" Hubbard is an uncanny look-alike of a young Hubbard. At least now, Glenn, you can make claims to being an erstwhile rock star.

"Year after year, economic theorists continue to produce scores of mathematical models and to explore in great detail their formal properties; and the econometricians fit algebraic functions of all possible shapes to essentially the same sets of data without in any way being able to advance, in any perceptible way, a systematic understanding of the structure and the operation of a real economic system." - Wassily Leontief, 1982 Have we improved since 1982? Was Wassily being a little harsh? Are our current models any better? Today we again turn to our exploration of the implications of complexity theory and the critical state and their applications to the market. Can we find some explanation for the seeming decrease in market volatility and an increased appetite for risk and leverage? The more I meditate on this, the more implications and explanations for market behavior seem to come to mind. What I hope to do is give you a way to understand the markets apart from the usual easy bromides.

It is Good Friday, and I am going to take the writing day off. Next week we will delve further into the rich mines we began to explore last week on complexity theory and fingers of instability. But I am going to give you something better than my poor missives. Today we look at the chapter by Richard Russell from my book Just One Thing . To find out more about the book, you can click on the book cover nearby or go to www.amazon.com/justonething. What can one say about my friend Richard Russell without using a lot of superlatives? Richard has been writing and publishing the Dow Theory Letters since 1958, and never has he missed an issue! It is the longest newsletter service continuously published by one person in the investment business. Richard is now 80 years old, and writes an extremely popular daily e-letter, full of commentary on the markets and whatever interests him that day. He gets up at 3 am or so and starts his daily (massive) reading and finishes the letter just after the markets close. He is my business hero. He was the first writer to recommend gold stocks in 1960. He called the top of the 1949-66 bull market, and called the bottom of the bear market in 1974 almost to the day, predicting a new bull market. (Think how tough it was to call for a bull market in late 1974, when things looked really miserable!) He was a bombardier in WWII, lived through the Depression, wars, and bull and bear markets. I would say that Russell is one of those true innate market geniuses that have simply forgotten more than most of us will ever know, except I am not certain he has forgotten anything. His daily letter is loaded with references and wisdom from the past and gives us a guide to the future. (You can learn more - and subscribe! - at www.dowtheoryletters.com.)

"To trace something unknown back to something known is alleviating, soothing, gratifying and gives moreover a feeling of power. Danger, disquiet, anxiety attend the unknown - the first instinct is to eliminate these distressing states. First principle: any explanation is better than none... The cause-creating drive is thus conditioned and excited by the feeling of fear ...." Friedrich Nietzsche "Any explanation is better than none." And the simpler, it seems in the investment game, the better. "The markets went up because oil went down," we are told, except when it went up there was another reason for the movement of the markets. But we all intuitively know that things are far more complicated than that. But as Nietzsche noted, dealing with the unknown can be disturbing, so we look for the simple explanation. "Ah," we tell ourselves, "I know why that happened." With an explanation firmly in hand, we now feel we know something. And the behavioral psychologists note that this state actually releases chemicals in our brain which make us feel good. We become literally addicted to the simple explanation. The fact that what we "know" (the explanation for the unknowable) is irrelevant or even wrong is not important to the chemical release. And thus we look for reasons.

This week the US Federal Reserve raised interest rates once again, for the 15th straight time. As everyone knows by now, the press release at the end of the meeting suggests that they will raise rates at the next meeting. But after that? Like children in the back seat of the car on a long trip, the markets keep asking "Are we there yet?" We look at that answer and more as we ponder what goes on in a central banker's mind. First, let's look at the actual FOMC statement. I think, given the background we will discuss in this week's letter, there are nuances that we can find which will give us a few clues as to future Fed policy. I step out on a limb here, or maybe it is better to stay I remain far out on the limb where I perched myself two years ago. It should make for an interesting letter. When the Fed statement is released, I typically get a copy within a short time and read it to see if anything is really new or different. Then I put it aside, knowing that early the next morning, Art Cashin, head floor trader for UBS and de facto sheriff at the NYSE (you see him on CNBC every day on Ron Insana's show) will send me a word by word analysis of the Fed statement as compared to the most recent past statement.